Sui Generis – Up 8% YTD Despite Net Short

With June having come and gone we are now halfway through the year and without hesitation we would suggest that the last six months have been unlike anything we could have imagined. We entered the year with a bearish view of the world that we maintain and the result is that the Sui Generis Investment Partners Master LP has been net short of equities every day of 2016, though some days more than others. One would not be blamed then for assuming that our fund has likely struggled in the face of a TSX that at June 30th had returned nearly 8% on the year. Not so. While providing our investors with downside protection (and often, participation) we have also managed to keep pace with the rising market in spite of being net short, and we believe we can improve on our 7.73% year-to-date return. June was another positive month for the fund showing a 1.21% gain and keeping pace with our goal to return at least 15% to our investors regardless of the market’s direction. In this note we will touch on the environment that we believe is setting up perfectly for us to do so.

If you’re reading this on July 14th then today is Bastille Day in France, the national holiday that commemorates the watershed moment in The French Revolution. The timing is fitting given the social and political climate that led to the storming of the Bastille. This isn’t a political note, we’re portfolio managers; but these things matter to stock markets and there is a distinct revolutionary feel to the world at the moment given the numerous political, social, economic and what’s most worrisome, military movements happening across the globe. Our March edition of Multiple Thoughts titled This Means War detailed our idea that growing anti-establishment sentiment would manifest itself politically in strong opposition to free trade and globalization. Not for one second did we believe at that time that Brexit was a legitimate possibility, but it makes perfect sense within the context of the discussion. Too many people have been left behind since the global financial crisis and this blowback against the status quo has now gone from something that seemed likely to happen to something that is now happening, and though we believe the consequences will reverberate throughout the world economy, for the time being markets don’t care one bit. The world’s 5th largest economy, the United Kingdom has voted to leave the EU…no big deal. Protests are proliferating throughout the US in the face of growing inequality and gun violence…meh. The migrant crisis in Europe is spiralling out of control…sad, but investors don’t seem too concerned. Economic growth is feeble, European banks are staring down the barrel of another bailout and S&P 500 earnings have declined for six consecutive quarters…outright bullish.

Though we see these as very real risks to the world economy without simple solutions, equities around the world are climbing the wall of worry and touching all-time highs. And while the absolute level of stocks means nothing when presented on its own, the relative value is what worries us as valuations are currently in the 98th percentile and the cyclically adjusted price earnings ratio (CAPE) is sitting at 27x or a full 25% higher than its historical average. To be clear, if the market was properly discounting these risks we might be inclined to be bullish but unless corporate earnings suddenly jump or these risks suddenly dissipate, we can’t get there. So for the time being high levels of risk and extreme complacency are not mutually exclusive, though based on both their historical relationship and everything we have ever known about investing they should become reacquainted soon enough. Why the breakdown in their relationship? How could it be that risk and reward have divorced from one another in such a public way? Her name is TINA.

We first became acquainted with this temptress only a few days ago while watching BNN here in Toronto. A bullish market participant was being questioned as to how they could justify continuing to buy stocks at these levels with some reference being made to the greater fool theory. Their response was a shrug and the word “TINA”. For the uninitiated this is an acronym for “there is no alternative”, and yes it’s the worst possible justification for buying stocks. We believe that by pushing interest rates to previously unimaginable lows and buying securities around the world to inflate asset prices the world’s central bankers are punishing pensioners. As well, they are mortgaging our future to avoid recession and a bear market at all costs as though they were no longer part of a normal business cycle. This is the reality we have lived in for some time now, it’s worrisome but it’s old news.

What really keeps us awake at night is the trend of “professional” investors becoming increasingly convinced by TINA and her promises of an ever-rising stock market. Perhaps we should give kudos because for the time being these individuals are correct in that they have suggested being long stocks, and stocks have gone up. We’ve chosen to go another route and at the time of writing every single one of our investors is at their high water marks so we assume they’re happy with our long/short approach, punctuated by a net short position. But there is an intellectual dishonesty attached to ignoring weak fundamentals and buying stocks simply to keep up with a rising market. In this we mean that we know very intelligent money managers who are buying stocks not because they think it’s the right decision, but because they think they have to. It is this behavior that has us worried about the risks investors (you) are currently exposed to because again, we do not believe the market is adequately discounting those risks. We say these things only because we truly believe them and want you to do well, wherever you’re invested. But the longer the normal cyclicality of the world economy and markets are suppressed the uglier it will be when investors wake up and TINA is nowhere to be found.